Tax-advantaged retirement savings vehicles such as 401(k) plans are supposed to help people sock away money for retirement. But far too often they are used as a piggy bank. You can argue that it’s your money, so you can do with it what you want. While that’s true, you may be sabotaging your financial future.
Making withdrawals to bankroll a vacation or a pricey purchase can have a lasting impact on the amount of wealth you can accumulate for your golden years.
“What we’ve seen change over the last 10 years is, instead of tapping a home value for equity, the vehicle is now the 401(k),” says Brad Bernstein, senior vice president of wealth management at UBS. “It’s terrible because it destroys your long-term savings for retirement from one of the largest sources of retirement savings.”
Borrow against 401(k) or take it outright
When it comes to taking out money from a 401(k), savers have 2 options. They can withdraw the money outright, face a 10% penalty and pay income taxes on the distribution. The other choice involves borrowing against 401(k) money and paying it back from each paycheck.
With respect to the 2nd move, the IRS lets you borrow half of the account balance, up to a max of $50,000. While borrowing for a home purchase or to fund an education are among the main reasons people take out loans on their 401(k) plans, there are plenty of other excuses to get to the cash. Vacations, home improvements, debt consolidation and big-ticket purchases are also common reasons.
Avoid the vicious cycle
An outright withdrawal from your 401(k) rarely makes sense because of the taxes and penalties involved, but even a loan may not be the best choice.
“If you’re borrowing to expand your lifestyle or to pay off debt and you haven’t fixed the spending problems, it’s going to be a real problem,” says Joseph “J.J.” Montanaro, a financial planner at USAA. “In situations where something is a need as opposed to a want, then the 401(k) is the best source for money.”
For serial job hoppers or those whose employment is on shaky ground, a loan against a 401(k) can be particularly problematic. If you leave your job before paying off the loan, you are typically on the hook for paying it all back within 60 days.
Can’t pay it back? Then you’ll have to take the income tax and 10% penalty hit on the amount you borrowed.
Diminished savings when borrowing against 401(k)
The biggest drawback: Robbing your 401(k) plan before retirement will diminish the amount you save. After all, if you borrowed $10,000, that’s money that is not growing with your other investments.
And it can create a disincentive to save altogether. A Fidelity Investments study of 401(k) loans found 24% of borrowers decreased their savings rate in the 1st year the loan was taken out, with 9% halting contributions altogether. Within 5 years of taking out the loan, 40% of borrowers reduced their savings rate from pre-loan levels and 15% stopped saving completely.
“At the end of the day, you are decreasing your savings for retirement,” says Michael Brady, founder of Generosity Wealth Management. “Yes, you are paying it back. But it would have been better if you could be adding to it.”